Will Dubai Be a Drag on Gulf Region?

DUBAI — With a dazzling display of fireworks that lit the night sky for miles around, Dubai officially added “world’s tallest building” this month to its trophy case of superlatives.

Burj Khalifa

The inauguration was intended to send a bravura message: Dubai, after a brush with default last year, was back. But for many investors, the silvery steel needle that soars half a mile into the sky will remain a fitting symbol of the hubris that led to the wealthy city-state’s burst property bubble.

Will the tarnish in Dubai spread to other oil-rich Gulf economies?

That question may be on several minds as world business and political leaders meet in Davos this week to “rethink, redesign, rebuild” the global economy.

A last-minute decision to change the name of the skyscraper from Burj Dubai to Burj Khalifa reflected a political shift within the United Arab Emirates. Dubai’s tower now carries the name of Sheik Khalifa bin Zayed al-Nahyan, the ruler of neighboring Abu Dhabi and the president of the emirates, who reluctantly rode to Dubai’s rescue last month with a $10 billion bailout.

The name switch is more than a grateful genuflection. It signals that Abu Dhabi, which controls 90 percent of the oil resources of the emirates, will begin to exert more control over the federal structures of the emirates. Dubai’s autonomy will be reined in, as will its penchant for flamboyant excess.

Despite the bailout, Dubai’s finances remain wobbly. The input of capital from Abu Dhabi prevented an embarrassing default on a $4.1 billion note by Nakheel, the property division of Dubai World. But Dubai World, the government-owned investment conglomerate, still has about $26 billion in distressed debts on its books. The cash left over from the bailout gives Dubai World a six-month cushion for restructuring some of that debt.

“I don’t see this as total salvation, but I do see it as a necessary and positive first step,” said Bill O’Neill, a portfolio strategist at Merrill Lynch Wealth Management for Europe, the Middle East and Africa.

Speaking at a news conference in Dubai last month, Mr. O’Neill forecast a slight contraction for Dubai’s economy in 2010 and “close to zero” growth for the economy of the emirates. The good news for the rest of the region, he said, was that the crisis appeared to have been contained within Dubai.

With most economists anticipating oil prices in the range of $80 to $85 a barrel over the next year, Saudi Arabia, by far the region’s most important economy, is poised for a strong comeback after last year, when it posted its first deficit in eight years.

The Saudi economy could expand by 4.5 percent this year, according to Goldman Sachs. “Clearly, Saudi Arabia, alongside the G.C.C.’s other hydrocarbon-heavy economy, Qatar, is ideally positioned to benefit from the ongoing cyclical recovery in the global economy and outperform its peers in the gulf region,” Ahmet Akarli, an economist for Goldman, said in a recent research note, referring to the Gulf Cooperation Council.

The Saudi economy grew by only 0.15 percent in 2009 as oil prices fluctuated from $35 a barrel to more than $80 a barrel. The Organization of the Petroleum Exporting Countries, dominated by Saudi Arabia, expects stable prices and a slight uptick in demand for 2010 following two years of what it described as “devastating declines.”

Production fell by 1.4 million barrels a day, or 1.6 percent, in 2009. The drop was driven by a record-breaking 4 percent decrease in demand from industrialized nations — a decrease that might continue this year, even as global demand is expected to rise from China, India and other developing countries.

The Saudis and other OPEC members were relieved last month when the Copenhagen climate summit produced only a vague commitment to reduce carbon emissions. While most world leaders, including President Barack Obama, expressed regret, Mohammad al-Sabban, the chief Saudi negotiator at Copenhagen, called the summit a “success” for his country.

The wild card for the region’s economic recovery, of course, is Iran, where economic sanctions, acute civil strife, regime change and even war are all possibilities for 2010.

The United States and its European allies continue to discuss imposing a new round of sanctions on Iran, the second-largest oil producer in OPEC, after Saudi Arabia. The Obama administration said sanctions would be designed to spare the general population while punishing the Revolutionary Guard Corps, which now controls much of Iran’s economy.

Officials in Washington and in European capitals have singled out Iran’s banking sector, which has a significant offshore presence in the emirates and Bahrain, as a likely target. The United States has already imposed stiff sanctions on Iran’s major banks, but the European Union, which remains Iran’s biggest trading partner, has yet to reach a consensus on punitive measures. For its part, Iran could retaliate by disrupting oil shipments through the Gulf.

If the region’s economy does regain some traction in 2010, one of the drivers — and one of the main beneficiaries — could be the burgeoning field of Islamic finance.

Islamic banks came through the financial meltdown of 2008-2009 in better shape than their conventional counterparts, mainly because they tended to be more conservative in their lending practices and because their Shariah-compliant regulations obliged them to avoid complex securities like derivatives and credit default swaps, said Kassim Dakhlallah, a professor of finance at American University in Dubai. “They also kept a high level of liquidity on their balance sheets, which helps in a crisis,” he added.

Islamic bonds, known as sukuk, are gaining credibility among Western companies and financial institutions interested in attracting investors from the Muslim world. Instead of paying interest, which is forbidden by Islam, a sukuk returns a profit based on revenue from an actual asset.

Last year, the General Electric finance arm GE Capital became the first major U.S. company to tap this market when it issued a $500 million sukuk backed by revenue from the company’s aircraft leases.

The market is expected to grow despite the wary moments last month when Nakheel, the Dubai developer, threatened to default on its sukuk.

If there is a lesson to be drawn from the Dubai debacle, it is to read the fine print.

Back when banks and other investors were tripping over themselves to get on board Dubai’s property speculation bandwagon, they assumed that the Dubai government stood behind Nakheel and the various other quasi-government business entities even though the fine print made clear that was not necessarily the case. One reason the investors made that assumption was because the country’s leaders wanted them to.

“Nothing was ever said in so many words, but the leadership here definitely went to some lengths to give people this impression,” one industry leader in Dubai said.

The Dubai government’s unwillingness to stand behind Dubai World stunned the global financial community and set off a small panic in markets around the world.

“From a legal standpoint, they might have been able to get away with it, but morally, it would have been wrong,” said the person, who spoke on condition of anonymity because of the issue’s sensitivity.

Abu Dhabi’s reluctant bailout — just hours before Nakheel’s note was due — rescued the situation for the short term, but the mere whiff of default has damaged the reputation of Dubai — and to a lesser extent the emirates as a whole — as an investment haven. The credit rating agencies have already dropped their assessments of Dubai’s government-owned entities and several of its banks. And this month, Moody’s said it would do the same to several of Abu Dhabi’s government-owned entities unless it received guarantees that the government stood behind them.

All of this means that there will be a little more caution on the part of investors in 2010 and a lot fewer flamboyant projects — like islands shaped like palm trees or ski slopes in the desert — in Dubai.